Monday, February 28, 2011

Brad Delong wrote a short post recommending Neptune’s Inferno as the best book he has read all year. I tend to read Brad’s recommendations - so - despite it being a long way from my usual reading material I got a (kindle) copy.

Neptune’s Inferno is an history of the Battle for Guadalcanal in the Solomon Islands - the first major amphibious invasion carried out by the Allies in World War II. It was also - along with Kokoda - a "Battle for Australia"*. The battle was fought after spies in the jungle reported that the Japanese were building an airstrip that threatened Australian shipping. (Keeping shipping open to Australia was a core priority of the US Navy - and rather important to Australia.)

Guadalcanal was amongst the Marine’s finest hour. It was also the hour at which they depended - more than any other time - on support from Navy destroyers - and seamen died in large numbers to provide that support. The campaign was fought originally without battleships and sometimes without aircraft carriers. The battleships were in port in California - not because they were not needed but because there was no way to supply fuel for them. The tankers were in the Atlantic convoys (or on the bottom of the ocean) and Hitler - by removing the tankers removed the battleships from the Solomon Islands. The aircraft carriers were limited by fuel and by the navy's (understandable) desire to protect them. In the end there were battleship-to-battleship battles - something that only happened a few times in WW2.

This is not a book review. If you like military history you will love this. If your love of military history does not go far from the various books about military incompetence then don’t bother.

I am writing to comment on American/Australian relations. There were in the Second World War several "Battles for Australia". One was Kokoda - a battle fought heroically by under-trained Australian ground troops.** The other was the battle for Guadalcanal - a battle fought by the (well trained) US Navy and the US Marines. Australians remember Kokoda but do not remember Guadalcanal. (Most Australians could not identify where it was despite having recent military involvement there.) However - to be blunt - we owe you.

And also to be blunt - we keep paying. If the American President asks for Australian support we give it. We were in Korea, Vietnam, the Iraq-Kuwait episode, Iraq and Australians are still dying in Afghanistan.

The critics on Australian-American relations state that the object of Australian foreign policy is to internationalize the corpses in American wars. The strongest supporters of the status quo will argue the same thing. After all - who else can we rely on to bring serious grunt to battles like Guadalcanal?

And thus it will be - Australia will wind up fighting US wars - just or unjust. And we will send our boys to die with your boys. And we will do that despite the fact that we do not vote for your Presidents and exercise very little say about what wars we fight.

So whilst I do not vote in the US elections - about half my readers do. So dear readers - read the Guadalcanal book if you like that sort of thing. (It is a darn good book in the genre.) But more important please ensure sensible political debates are had on matters of military adventures. Please.

John

*The term "Battle for Australia" is misleading as there is little direct evidence that the Japanese ever planned a direct invasion of Australia. The Japanese did however bomb Darwin (and in a minimal sense Sydney). They also extensively targeted Australian shipping routes. The Japanese campaigns were clearly targeted at control of Australian waters. The Japanese invasion fleet repulsed at Coral Sea was probably headed to Port Moresby.

**It is not that the Australian military is poorly trained and hence deliberately sent poorly trained troops to Kokoda. Its just that our best troops were in Africa at the time fighting the Nazis. We were in a better position when the African troops came back.

PS. The (appalling) politics of the Solomon Islands is a direct result of the power structures left behind by Americans at the end of the second world war. If someone wants to examine the effects of nation building (or the lack-thereof) after military destruction then Guadalcanal (where there is an on-again-off-again civil war) would be a good place to start. Australia dropped a peacekeeping force on Red Beach in Guadalcanal in 2003 - a reproduction of the original American landing.

PPS. There was another "Battle for Australia" - also largely fought by the Americans - the Battle of the Coral Sea. That was one of the major battles of the War - with both the Americans and Japanese losing an aircraft carrier. The US carrier Yorktown was also damaged - and as a result was lost at Midway. Coral Sea was the precursor to the Guadalcanal campaign - if the Japanese could not get carrier superiority in the area the idea was to build airstrips on unsinkable carriers (islands).

Thursday, February 24, 2011

We have just been through six years when almost any company that could be purchased by private equity and was potentially worth purchasing by private equity has been purchased by private equity. With the exception of about eighteen months, PE firms could issue lots of low yield debt to buy the assets. I am an equity manager - and in searching for good assets private equity firms are my competition. I dislike them for it. (Never have so many Harvard MBAs been concentrated on so many small cap stocks...)

There is only one exception to this - and this exception proves the rule: there are a few small companies that have a dominant (often family) shareholder where the (family) shareholder won’t or can’t sell for personal/legal/structural reasons. Some of these companies might be reasonable value because the PE firms have not had a look in. Indeed, we have about 10 percent of the fund invested in companies in France that fit this exception. One of our most profitable positions has been a German company with a dominant (and immobile) family shareholder.

Private equity funds are also the biggest competitors to other private equity funds. All this competition means that private equity shops are doing worse and worse deals. Its got to the point where PE funds buy fake companies (see Carlyle with China Forestry and I suspect others).

Running a small hedge fund, I would usually want to buy small caps on which I had done superior analysis. Alas, when I look at small caps - even medium caps I keep finding expensive, dodgy and well promoted stocks. Small caps are a land of shorts. The good stuff - and then the less good stuff left behind - has been picked over by numerous PE shops.

I do serious research. I will pay someone to stake out a factory in China and count the trucks going in and out. I talk to suppliers and customers. And by and large almost all of that research is no good for finding longs. You see the PE shops have more resources than me - and when they find something even half way good they issue low yield debt and buy it. The low yield debt that is everywhere is my competition - and I hate competing with someone whose capital costs less than a third of the returns I target. The low yields that PE funds can issue debt have now resulted in low ex-ante returns for small cap investors.

Large caps by contrast are surprisingly inexpensive (however most of them have warts).

For instance Google - and I am just picking Google - has a PE ratio below 20 when you net the cash out - and has an enormous tailwind. At the moment there are 3.4 billion cell phones in the world and only about 100 million connect intensely to the internet. Most of those are iPhones. In five years time Android phones with the capabilities of a current iPhone 4 will retail below $100 - possibly far below $100. The dumb phone will cease to exist - and almost all phones will connect to the internet. Google will dominate that ecosystem. The tailwind is enormous. Sure Google faces headwinds too (their search quality is being eroded by spam and Facebook is stealing internet time and even search loyalty). But in a different environment you might say Google was cheap.

Microsoft is under 12 times historic earnings - and far less than that if you net out cash. And sure it is problematic (I am writing this on a linux computer and in a few years the dominant computing device will be a phone - probably an Android phone). But the cash flows look stable enough for now. And the biggest mobile phone company in the world has just agreed to distribute their operating system.

Vodafone is at a PE well under 10 times - but it has a history where it has never failed to disappoint. When I told a UK fund manager that my biggest position is Vodafone he looked at me with pity. (It was of course their biggest position a decade ago - and what they were really feeling was self-pity.)

Now these are not historically stretched valuations - but they are not outright bargains either. They are however a bargain compared to long term government bonds and they are absolutely a bargain compared to the average small cap.

I don’t particularly want to express a view on inflation or deflation. Suffice to say we have seen a movie which had an unbelievably brutal deflation. That was Japan. Ben Bernanke has also seen that movie - and he has determined that it will not happen in America. He will expand money supply to stop it. A deliberate money supply expansion on this scale in response to a huge deflationary threat is an experiment and we do not know the outcome. It could fail (you know the saying - you can lead a horse to water but you can’t make him drink). It could succeed beautifully producing 4 percent inflation and getting the economy out of the rut. Ben Bernanke said on 60 Minutes that he was “100 percent” sure that he could control inflation at the end of it. I need to stand outside a factory and count trucks before I am 100 percent sure the trucks are not coming - but unless I have a method of direct verification I am not 100 percent sure of anything much. Bernanke is a little too certain. Whatever: put a weighted probability on inflation or deflation and you would conclude that long-dated government debt - or a deflation bet - is a very risky bet. (It may wind up ex-post being a good bet - it may wind up being a terrible bet. Whatever - right now it is a risky bet.)

Warren Buffett wrote an editorial in the New York Times on 16 October 2008 suggesting that people buy American equities. He had already spent all of his non-Berkshire personal account - so most of his purchases were made with the S&P above 1000. Warren is not stupid and his return expectations were at least 7 percent per annum. (He is after all Warren Buffett and he is rather good at this stuff. Better than me or any of my readers.)

Two years have passed - dividends have been a couple of percent per annum - so the current equivalent level S&P level (allowing Buffett’s 7 percent in the form of capital appreciation) is about 1100. The S&P is currently about 1300. Today you are buying 20 percent more expensive than Buffett suggested. (That does not sound like a bubble to me.)

For most of Buffett’s purchases buying 20 percent more expensive than Warren turned out just fine. And I suspect it would turn out just fine now too.

So here we are in a strange world where large caps are not bargains - but they are, by and large, not frighteningly expensive. If you were to buy a diversified pile of American large caps and sit back in a decade you would probably be OK - indeed better than OK. But small caps - the area on which my expertise would normally be most productively targeted - are frighteningly expensive - and the market is riddled with stock-promotes and outright frauds.

So - with exceptions such as my French and German “family stocks" we are mostly long large caps (eg Vodafone, Google) and short small caps (about 50 names, mostly frauds).

Alas I cannot analyse Google with any degree of precision. A five year earnings estimate made by anyone at Bronte would be worthless. I have no idea how many smart phones will be Android tied into Google and how many will be Nokia/Microsoft tied into Bing. I have no idea how much damage Facebook or even Blekko will do to Google’s franchise. The world is too big and too complex to pretend we know this stuff. If you can predict this five years out then you are way smarter than me.

The same is true of most of the large caps in our portfolio. I think on the balance of probabilities any one of them will be alright. They are almost certainly going to be alright on average. Predictions beyond that run the risk of pretending I know more about the future than I do about the past or present.

Still - having the overwhelming feeling that large caps are OK - and small caps disastrous I figured I could focus my attention on finding and shorting really dodgy small caps (which we have done to considerable success) and buying a diversified pool of large caps (where our success has been more limited). That figures - I can add value on the small caps - it just happens that value has been on the short side.

Picking fund managers

If I figure large caps are on average OK - but that I have no expertise in picking them - then maybe I should buy the listed fund managers. I understand them - indeed I used to work for a listed equity manager. Equity managers are levered plays off large caps in general. If the large cap equities perform well the managers will get flows - and they will perform doubly well. Fund flows to domestic large cap managers have been terrible for some time - and a possible turn around in them is the source of the double leverage to the upside.

Flows however are not inspiring. One of the better articles of late has been by Derek Pilecki of the very small firm Gator Capital. He compares the flows of the majors and suggests buying Franklin Resources (NYSE:BEN). The flows last year were almost 70 billion - the best in BEN’s considerable history.

We are impressed - but we are not exactly thrilled. The flows - even at a mutual fund group with way-better-than-average flow data - is dominated by fixed income flows. That capital going into fixed income is going to yield the intermediate bond rate (a couple of percent) minus fees (low but not trivial relative to a two percent yield) plus something for the extra risk the fixed income fund takes on. There is no double leverage for us there!

And just to add insult to injury all those flows want to earn a little more than 2 percent - and the easiest way to juice your yield is a buy a few covenant-lite bonds from our friends in the PE shops. Franklin’s fund flow increases - rather than decreases - my lament about this market.

And thus this dumb-and-annoying market goes on. We don’t want to fight: fighting the tape can be awfully expensive. But whilst we won’t fight it we also don’t want to dance just because the music is still playing.

And hence we focus on diversified fraud shorts because we can add real value. And the rest is invested very conservatively (meaning large cap equities). We are adding little to no value there - but at least it is “better than bonds”. Combined we are doing alright (indeed quite well) - but it is a day to day struggle. Moreover whilst the frauds can be interesting - its a niche concern - and, besides, most of them I can’t or won’t write about. So, for my readers, it results in less interesting blog posts.

Wednesday, February 23, 2011

China Agritech - as has been discussed in previous blogs - manufactures and loads 200 thousand tonnes of dry fertilizer and 13 thousand tonnes of liquid fertilizer using a mere 105 manufacturing staff and just over 6 million dollars in capital.

Obviously these staff are super-strong - as just filling and sewing closed the fertilizer bags and loading the trucks would be problematic. My previous posts have focused on the Herculean efforts of staff just loading trucks - and only at the Anhui plant. The rest of the company of course has to be much bigger than that.

This is pretty sophisticated stuff. Most companies doing nano-production measure their output in something ranging from thimbles to maybe one or two tonnes. A123 has - as I have blogged about earlier - had enormous expenses in scaling their manufacturing.

But China Agritech is special. It does nano-prodution using sophisticated things I do not understand (like nano-honeycomb embedding technology and microelement deep complexing) on the scale of hundreds of thousands of tonnes per annum. And it does it with minimal staff and just over $6 million in plant and equipment.

Whilst I do not understand how they do it fortunately we have a highly qualified guide. His name is Wayne Tsou - and he is the managing director of Carlyle Asia Growth Partners. He is of course entirely suited to the job. He not only has a Juris Doctor from the Harvard Law School - he is a scientist! He has a Master of Science from CalTech and a Bachelor from University of Michigan. Sure he is an electrical engineer by training - but so is my business partner and I don’t hold that against him...

Anyway Wayne Tsou has (at least before the controversy) vouched in the press for China Agritech and their technology. To quote: "we [Carlyle] are encouraged by the Company's current operations and future outlook. Carlyle always has been active in investing globally in technologies and companies focused on sustainable development. We intend to continue to provide resources and assistance to help China Agritech achieve its strategic goals and expand in the Chinese agricultural market."

Fine words - and as Carlyle is a fine firm I presume those words are backed by actions and that Carlyle really is in there helping China Agritech with its technology. And that Wayne Tsou can explain what is meant by nano-honeycomb embedding technology and microelement deep complexing.

I only wish he would.

You see I have approached Mr Wayne Tsou to answer questions about Carlyle’s involvement in China Agritech and what contributions Carlyle made to their technology. Like the other Carlyle participants in this well promoted stock Mr Tsou has been strangely silent.

Nonetheless Carlyle is a reputable firm - and if they say they are dealing with someone who can manufacture nano-products on a vast scale without much in the way of staff or capital equipment it is not for me to disbelieve them. If they think investing in nano-honeycomb embedding technology and microelement deep complexing makes sense - then I presume they did some due diligence.

Friday, February 18, 2011

This post continues to demonstrate the super-human staff of China Agritech. It is proof that the US cannot possibly compete with the Chinese in any total factor productivity sense.

I covered the super-hero status of China Agritech's staff in a previous post. To recap the Anhui plant of this company - according to company filings - manufactures 100 thousand (metric) tonnes per annum of dry fertilizer. My estimate (again based on the corporate accounts) is that the plant uses just over $2 million in capital equipment and somewhere between 30-40 staff to do this.

100 thousand tonnes is 2.5 million 40kg bags of fertilizer. This fertilizer has to be manufactured (something that normally requires some plant), put into bags, have the bags sewn shut and then loaded onto trucks. These staff may look like Clark Kent - but underneath their clothing are men-of-steel - men who ordinary companies cannot hope to match.

To further demonstrate the utter superiority of China Agritech and their staff the company have released a further 11 photos of their Anhui plant. (Peculiarly these photos are labelled 1 to 13 on the China Agritech website - but photos 8 and 11 are missing.)

None of these photos deal with the manufacturing of the fertilizer - something that is usually capital and manufacturing intensive - all we see is a spartan bagging plant and the Chinese Adonis who ply the floor.

This is the land of superhuman staff. Remember 2.5 million bags per year is 17.4 bags per minute, 8 hours per day, 300 days per year.

Photo 1

This is a photo of some trucks. Obviously it contains none of our super-heros but it gives you a scale of what they load. Assuming the trucks carry 60 tonnes they have to load 1666 of these per year - say 5.5 per day based on a 300 day year. Maybe 5 per day if there are more than 300 working days per year.

Photo 2

This is just another photo of the trucks. The number plate has been pixelated. However we can begin to get an estimate of how many bags go on a truck. This looks like about 20 bags high, 15 bags long and 4 bags wide (ie 1200 bags) plus another few hundred bags on top. Call it 1500 bags. That is my 60 tonnes.

Note the bags on the trucks are not sitting on pallets suggesting fork lifts were not the main way of loading this truck.

Photo 3

This is our first photo inside the plant. We see some bags on the ground (no pallets). We also see an a loading chute and an industrial sewing machine with two (large) white spindles. These are used to sew the bags closed. In all the photos we only see this machine so if the needle breaks or the thread runs out we stop loading. Moreover we do not see good automated ways of handling the bags around the sewing machines which suggests the bags are lifted up.

Photo 4

Now we see two of our superheros - strangely standing on a pallet - but putting bags on the ground. Thees bags are clearly labelled China Agritech (note there are no such labels on the bags on the truck).

The superhero on the left has his back arched. He has clearly not seen any of the literature on the correct way to lift heavy loads - if he were an ordinary person he would be stuffed within hours of this work-pace - but he is a superhero (along with all the other Chinese superheros).

Photo 5

In Photo 5 we eventually see a forklift. The bags are not on pallets on the truck - but they are lifted up to the truck level using pallets and forklifts. This will of course reduce the workload our heroes face. So far the time-and-motion study is peculiar. The fertilizer is manufactured in a part of the plant we can't see. It is taken by conveyor belt to a loading chute and then - by hand - moved to an industrial sewing machine. The loaded bags are stacked on the floor. They are then re-stacked onto pallets and then moved by fork-lift to truck level. (I point out that most factories have an elevated loading deck so that all the heavy stuff starts at the level of the loading tray of the truck.) After that they are taken off the pallets to be loaded onto the truck (presumably by hand). (I presume they loaded the trucks in the first two photos - though we should note that the labels of the bags disappear...)

Photo 6

Photo 6 we have one pallet load being moved by a forklift. All the rest of the super-heroes are standing around. I remain puzzled as to why the other bags are not on pallets - after all I presume the too will also be moved by a forklift. [There is an alternative explanation - which is that the bags are being delivered to the Ptomkin Village by forklift... that would explain why in photo 4 we mysteriously see bags being taken off the pallets by our superheroes. However that explanation does not hold up - because in this photo people are milling around the sewing machine - and they look to be sewing up a bag.]

Photo 7

Photo 7 proves the point that the sewing machine and loading facility is being used. The dropping of fertilizer into the bags (understandably) creates dust. Our staff must work in that dust - and so now they have donned dust masks. They must however sweep this factory incessantly because there is no big piles of dust on the floor - limited footprints and the like.

We also see - for the first time - a tool which explains our heroes amazing productivity - a lifting trolley. Its a pretty simple one - but hey - its a tool. Maybe our heroes are human after all.

Photo 9

There was no photo 8 on the website so we skip to photo 9.

Interestingly the bags have all changed color and there are lots more of them. They are loaded onto some dolly-intermediate size truck whereupon they will need to be loaded onto the main truck. The handsome Adonis capable of all this heavy listing are absent.

Photo 10

Our handsome Adonis is back. He is putting a bag on the pallet - or is he taking it off the pallet. Anyway it is yet another piece of manual handling of heavy bags. Still he is strong - and he must be amazingly productive.

There are several more superheroes in the background. They are also fiddling with bags - but none is actually lifting.

Finally we now have two lots of bags - one yellow with a hard to read logo - the other white with no logo. The stuff on the ground (and coming out of the white bags) is black whereas the dust in the other room is white. Obviously we are dealing with multiple products here.

Photo 12

Photo 11 is missing - so we jump straight to photo 12.

We have a fully laden truck we are now moving away. This one contains bags with the China Agritech logos on them. Again the bags are lifted to truck level using a forklift - but they are loaded onto the truck without pallets.

Photo 13

We are back in the factory. Some bags are on pallets. Some are not. The white dust that required dust masks is gone attesting to the efficiency with which this plant is cleaned.

Some notes

This plant represents half of the dry fetilizer the company produces - and a substantial portion of the company revenue.

The stock price of China Agritech has fallen from 30 dollars to 8 dollars (with most that fall happening before any shortseller went public about their concerns). The market cap is still 165 million dollars.

If you look at the equipment and plant shown in these slides you do not see anything that looks like even 5 million dollars - let alone a substantial fraction of the market cap. But that is not what you are buying.

You are buying Adonis - nah - Adonis times 105 (the total manufacturing staff of the company). No workers anywhere in the world demonstrate this sort of productivity.

Market cap of the company: 165 million dollars
Value of the plant: not very much
Owning your bit of 105 Adonis: Priceless.

Thursday, February 17, 2011

Rock climbing equipment is sold by name and reputation. There is not a government standard but climbing equipment is tested to destruction by the International Mountaineering and Climbing Federation (the UIAA). The UIAA produces one of the best private safety standards in existence.

Now to add to children's toys containing lead there is fake climbing equipment coming out of China. Petzl - a reputable manufacturer - has been putting out warnings about equipment which copies their logo and stamps but does not meet UIAA standards. The equipment fails under 70 percent of required test loads.

The Chinese frauds I write about will hurt you financially.

This Chinese fraud will splatter your brains on the ground.

Whilst it is trite to say fake rock climbing equipment is a geo-political issue fake rock climbing equipment and lead in toys will fan protectionist flames - and I doubt that will be constructive.

Bluntly: corporate manslaughter through fraud is something no civilized society takes lightly. This is headed in that direction.

Tuesday, February 15, 2011

China Agritech has put out an eight page shareholder letter rebutting claims of short sellers. Readers know that in the past I have been inclined to take such letters under extreme caution.

But in this case I take the company statements as the gospel truth. They illustrate just how miraculous Chinese productivity levels are.

Firstly China Agritech claim all their production facilities are working normally and give a few addresses. (The addresses differ from the addresses in the 10K – a new complication.) They also give some photos. Here are the photos given of the Anhui facility.

The gate to the Anhui facility is the same one photographed by Lucas McGee – the shortseller who put out the scathing note on China Agritech. [There has been some difficulty finding that facility.]

These photos from China Agritech – combined with the annual report - allows us to illustrate amazing total factor productivity levels in China.

The annual report gives the company staff numbers:

As of December 31, 2009, we had approximately 305 full-time employees, of which 45 were administrative and managerial staff; 150 were sales staff and 110 were manufacturing workers. We also hire temporary manufacturing workers to supplement our manufacture capabilities at periods of high demand.

The company has three dry fertilizer plants and a liquids plant. The Anhui plant however is half the total dry fertilizer – so at a guess it represents about a third of the plant and equipment and a third of the staff. (This is just a good educated guess – but the analysis would apply to all the other plants as well.)

So lets suppose – just running these numbers – that say 37 staff work at the Anhui plant (that is a third of the manufacturing staff).

The Anhui plant – also according to the annual filing – produces 100 thousand (metric) tonnes of dry fertilizer per year. The bags in that photo are 40kg bags – so they produce 2.5 million bags per year – and they do all that with 37 staff.

The photograph – the elusive loading facility for which I searched – shows less than 100 bags - loosely - and I would guess manually - stacked on top of each other.

To move 2.5 million bags of fertilizer annually you would need an enormous army of manual workers whose muscles bulged like Popeye or machines. I presume you would use machines.

I am not a factory guy – but I presume fork-lifts would be pretty basic equipment. But if they used fork-lifts then the bags would be loaded onto pallets (again I am not a factory guy - but I am used to seeing pallets). Instead – and here is the photo again – they are stacked somewhat irregularly on the ground.

These workers are amazingly strong. They move 2.5 million bags of fertilizer with nary a fork-lift.

Of course there could be some heavy moving kit outside the photo. So I went looking at the accounting for property plant and equipment. Here is an extract from the last annual:

Yes – that is 5.8 million of gross manufacturing equipment and 0.6 million of vehicles. A third of that equipment (my estimate) should be at Anhui.

So with just over $2 million worth of equipment the company claims to be able to manufacture and load 2.5 million bags of fertlizer per year. Oh, and they do without an enormous army of low-paid workers – but a mere thirty-something superheros.

America is forever stuffed. Westerners can never compete against this.

John

Disclosure: Bronte remains short China Agritech (indicating we do not think the above calculation should be taken very seriously except as an exploration of the accounts and claims of the company). "Anne" Wang Zheng - the Carlyle nominee China Agritech's board has still not got back to me. Perhaps she can shed more light on these amazing productivity levels.

Sunday, February 13, 2011

I have a friend with a fair career as an analyst in Asian private equity funds. He describes the central debate as being between the “Guanxi guy” and the “Analyst guy” (in his world they are mostly guys) and he says the “Guanxi guy” has won almost all of the battles.

At Private Equity (PE) firms the debate as to which deals to do and what price to pay has been between the Analyst guys and the Guanxi guys - and with the Guanxi guys winning almost every time. Analysts - when they have reservations about deals - are seldom heeded.

Some analysts - not wishing to besmirch their reputation with bad deals done for the wrong reasons struck out and started their own small private equity funds. When they find the deals they try to fund them and discover that the banks (or their Guanxi connections) want to take a piece of the equity. I guess that is the price of doing business. But even after paying up they find the banks want to charge them over-the-odds for funding.

So the deal goes to some Guanxi guy - and the banks queue up to do the funding at low spreads. (Whatever you say Sir says the banker...)

And so - in the great Guanxi vs Analyst debate Guanxi repeatedly wins.

Guanxi is less important in the West - but connections remain important. The definitive Western Guanxi firm is Carlyle. Carlyle is a private equity firm known for employing senior political figures and using those connections to win deals - but also for their knowledge of how government functions. The list of famous employees is large and include:

Carlyle is conspiracy theorist's dream because with all of those famous and well connected people the company understandably has important and profitable investments in the defence establishment.

But in Carlyle’s defence - many of these people not only bring connections but they bring knowledge and understanding of what is important to government and the defence establishment. The first President Bush for instance was also the CIA director - he almost certainly knows what is important to the CIA and how to sell stuff to them - and he would know that without exploiting any connections. These people are hired for the connections and for their knowledge.

Carlyle has taken this way of doing business to Asia and has hired many important and well connected people in Asia. I listed a former Phillipine President and a former Thai Prime Minister. There are many more of these people in China - notably the children of party officials.

Alas I think Carlyle’s business model in Asia is fundamentally flawed: we can see this through a purely hypothetical example.

Imagine if Chelsea Clinton went to work in business and to sell her connections. (I know nothing about Chelsea Clinton other than she got married recently - so this example is purely hypothetical.) And suppose that with considerable hard work at some Wall Street or Private Equity shop she wound up with $5 million. (As I said I know nothing much about Chelsea.) We would not be terribly surprised if Chelsea wound up with $5 million - we might think it unseemly - but it would also by Western standards not be terribly surprising.

However if Chelsea - through nothing other than her connections - were to wind up with (say) $500 million then that would be unseemly. Journalists would be all over the story and the integrity and morality of the people involved would be questioned. Indeed it would be so unseemly it would not happen.

There is a line here - $5 million is sort-of-OK. $500 million is clearly not. I suspect the line is at high single-digit or low double digit millions. Obviously the line is higher for a President than it is for a President’s daughter. Whatever: the social sanction matters.* The cynics would argue that there is a socially acceptable amount of looting. I prefer to think that wages - particularly of people who sell their “Guanxi” are socially conditioned.

That social sanction is considerably different in Asia. There are several “Princelings” in China (children of party officials) who have made hundreds of millions of dollars (or more). Suharto in Indonesia complained that that which the high-and-mighty in Washington thought of as “corruption” he saw as “family values”.

And thus we see Carlyle’s problem in Asia. In the United States the Guanxi guys will work for single-digit millions annually and think they are well paid. That is all they are entitled to. Such limitations on entitlement do not exist in Asia - and the Guanxi guys are likely to see Western funded private equity shops like Carlyle as piggy banks to loot. Sometimes they will be looted by the Guanxi staff but more likely they will be looted by Guanxi connections of of the Private Equity shop's Guanxi staff. And the looting will not be a million or two dollars here and there - it will be for every penny they can extract. The losses could be enormous.

To this end I present to you China Forestry. China Forestry was a billion USD Hong Kong listed Chinese company with many Private Equity funds having stakes. The leading stakeholder is Carlyle (or more precisely funds belonging to Carlyle’s clients). The stock has been suspended after admitting “accounting irregularities”. But it is worse than that.

China Forestry had a business model which consisted of fast-growth forestry to extract greenhouse gas credits - a business model that barely made sense to some analyst guys that looked at it. However it was a business model that made sense if the company had enough Guanxi - enough connections to extract a really bad (ie nonsensical) deal from the Chinese government. And the holders of China Forestry to some degree believed just that. They believed in the Chinese Guanxi. And implicitly they believed the deals were being bought to them by the Guanxi of their staff.

Now China Forestry remains suspended. No reasonable questions are being answered - so I am going to reveal to you the Analyst gossip: the bulk of the forests do not exist. Sure they had some “front” - plantations they would take potential investors to. But the vast bulk of the business was a fiction and “accounting irregularities” is code for “fiction”.

Oh - and Carlyle has dusted 105 million dollars.

If this is fraud then Carlyle has a little egg on their face. After all - what is the point of having all those investment professionals if they get dusted by the simplest of frauds. The whole point of private equity is that by pooling capital you can get insider positions and you can run the company for cash - for the benefit of your investors. But if your “insider position” doesn’t even allow you to spot the business does not exist then your insider status is worthless. You might as well close up and go home. You have no right to be in business.

This blog has been detailing another stuff-up of Carlyle. I am short China Agritech - a company listed on the NASDAQ with operations in China. At least the operations are meant to be in China but after considerable looking (only part of which has been detailed on this blog) we cannot find any convincing evidence that the bulk of the operations exist. In this case Carlyle is the biggest investor and has exercised its right to appoint a board member. Again it looks like they have been dusted.

The analyst guys are cock-a-hoop. They think that now the great Analyst-Guanxi debate will now - at least sometimes - be resolved in their favour. I think that is optimistic - this sort of “network capitalism” is too entrenched for a few stuff ups to upset. What is required to blow this apart is a collapse of the entire network.

Only after the collapse of network capitalism will the system be cleaned up and capital be allocated on the basis of analysis rather than connections. Whilst I am only nominally an Austrian economist - there is a long empirical history that this sort of stuff lasts until it doesn’t - until it has its “Minsky Moment” and only then is it replaced by something more sensible.**

So - on the basis that the system really is entirely stuffed up - and a blogger in Australia can find the empirical evidence for that stuff up I am predicting the collapse of the Asian Private Equity business. And Carlyle - the most Guanxi of all firms - will be the centre of that collapse.

John

Note 1: The other investment in Asia I am following which - at least on my analysis - barely exists - is China Media Express. CCME has been the subject of a few blog posts - but the main argument for the veracity of the company is the investment by Starr Asia. Starr is Hank Greenberg (ex AIG). Hank has more Guanxi than any other Westerner in China. He is an impressive man. However I suspect he has been done by his Guanxi here too.

*Note 2: Chelsea Clinton did work for Avenue Capital Group (a hedge fund and private equity group). However this has been entirely without scandal. In the West it usually is without scandal.

**Note 3: It is entirely possible that post-scandal the capital will be allocated according to the time-honored Asian tradition - stick the losses to the foreigners and the profits to the guys with Guanxi. (See Asia Pulp and Paper or GITIC for examples.)

Friday, February 11, 2011

The new consensus is that emerging markets are lower risk than developed markets - they have more favorable demographics and more sound fiscal policies.

They also have more colorful politicians.

This - the best quote in Wolfensohn's book - should give believers in the new consensus pause:

In early 1997, I met with the Indonesian President Suharto in Jakarta. The president asked me ... what I was doing raising the subject of corruption as an issue. I told him we couldn't talk about development without addressing corruption. He replied, "Well, you come out here from Washington with these high ideas to tell us about corruption. But what you call "corruption" I call "family values".

Thursday, February 10, 2011

In the last post I (erroneously) showed pictures of a gate of a plant supposedly leased to China Agritech. This was the photo as supplied to me.

The sequence was that the American lawyer in Shanghai who I hired to do this project had a (junior) colleague in Anhui for New Year. Her family came from Anhui.

She visited the site. She got several photos of the plant by poking in the Window but did not supply a photo of the gate. I have included one - it is a metal-working plant as advertised. Alas she supplied me the photo of the gate from the website of the metal working company - not a photo she took herself.

So my Shanghai lawyer went to Anhui (standing room only on the train!) and took the photos himself today. He was - when seen taking photos - escorted quickly off site. However he found the mysterious China Agritech office.

Here is the building on site in which the China Agritech office resides.

There are more modern factories on site - but this is the office building.

China Agritech has its office on the second floor on the right hand side of this building. The office was deserted - it was after all the New Year holiday. It is not large - but this office is the only evidence that China Agritech had any facilities that we found.

There was no fertilizer plant on this site - even though this was clearly the low-rise site where - according to the SEC filing - China Agritech leased its Anhui Plant.

Finally the road to the site was not a rutted road as described in the Lucas McGee report - indeed it was a large site with more than one gate. Here is one gate - my contact was sent off site before he photographed the gate as photographed in the last post.

We have now clearly found China Agritech facilities - but they are NOT the plants as described in China Agritech filings. They are however at the addresses given for those plants in the Agritech filings.

Wednesday, February 9, 2011

THIS POST HAS IMPORTANT QUALIFICATIONS - SEE THE POST SCRIPT. PLEASE READ THE QUALIFICATIONS AS AN IMPORTANT PART OF THIS POST.

China Agritech is a NASDAQ listed Chinese company that is – according to its SEC filings - in the business of manufacturing and distributing organic fertilizer.

The annual filing lists their capacity as follows:

... annual production capacity as of December 31, 2009 was approximately 13,000 metric tons of organic liquid compound fertilizers whereas ... annual production capacity for granular fertilizers as of December 31, 2009 was approximately 200,000 metric tons, consisting of 100,000 metric tons in Anhui, 50,000 metric tons in Harbin, and 50,000 tons in our newly completed plant in Xinjiang.

(a) A hitherto unknown shortseller (Lucas McGee Research) had released a report that suggested that key plants either did not exist or were entirely incapable of producing at the levels indicated in the annual filings. Lucas McGee research - as company promoters have been keen to point out - operates out of a virtual office and have a very limited history.

(b). The biggest shareholder is the world's most powerful private equity firm (Carlyle). I did not note – but Carlyle has filed a prospectus to register (and hence sell) their stock.

(c). The company has issued a denial of the shortseller report and claimed that all their plants and distribution centers are as listed in the annual filing.

I have a short position in the stock. I am keen to verify or reject the claims in the short seller report. (If I rejected the claims I would switch and go very long the stock. The stock is on-face cheap - and it is liquid enough that I could change my position in minutes.)

I wrote to Carlyle – and to Anne Zheng (a staff member of Carlyle and Carlyle's representative on the board of CAGC) – to see if Carlyle would confirm or deny the shortseller report. Alas I got no answer.

That makes research a little harder. This post is a summary of my research efforts.

The research efforts of course wound up against the normal epistemological problems of proving the existence or non-existence of things. In this case, if you find the plants and you count the trucks entering and leaving the plants with amounts of fertilizer on them consistent with the company filings you have proved the existence of the company and disproved the short case.

If however you do not find the plants you have not proved the short case - the plants could be somewhere else - or closed for a reason - or you could have the address wrong or any other similar snafu. It is hard - nay impossible - to prove a negative.

So - if the short case is right - the best I could expect to do is find data consistent with the short case. I did not expect to be able to prove the fraud.

The key shortseller allegations

Here are the key shortseller allegations as stated by Lucas McGee (the shortseller):

Sinochem (a claimed large customer) has told us that it does not sell any Agritech products

Government officials in China told us that Agritech does not have a license to manufacture granular fertilizers, which the company claims are its largest product line.

After visiting Agritech’s reported manufacturing facilities in Beijing, Anhui, Xinjiang, and Harbin, we found virtually no manufacturing underway. The single exception was the facility in Pinggu County on the outskirts of Beijing, where the plant was not in operation on the Friday when we (Lucas McGee) visited but local people told us that it has sporadically produced some liquid fertilizer over the last year.

Plants in Bengbu, Anhui (supposedly the largest), Harbin, and Xinjiang were completely shuttered.

Obviously these are allegations that go right to the heart of the company. Instead Lucas McGee suggests that money is being stripped out of the company by inflated rents to related parties.

If the Lucas McGee allegations are correct then the company will probably trade well under a dollar at some future date.

The company has categorically denied these allegations. Firstly it has pointed to a contract with Sinochem previously filed with the SEC (I will get to that contract later). Further the company has photographs of bags of granular fertilizer and some liquid fertilizer. And it has said that “the company and its subsidiaries are operating normally.”

As stated – after repeated requests – Anne Zheng (the Carlyle executive on the China Agritech board) did not confirm or otherwise vouch for the company's position.

Doing the work myself

Given that I could not rely on Carlyle, I employed a lawyer in China to visit the plant and see what they could find. This was made somewhat more difficult than usual because of Chinese New Year celebrations. You would not expect the plant to be operational during the holiday – and hence you could not check the volume of the plant by, say, counting trucks visiting.

The Anhui plant

I chose the China Agritech plant in Anhui because (a) it is listed as the largest plant run by the company – doing 100 thousand tonnes per year of fertilizer, (b) the Lucas McGee report suggested that it was shuttered and (c) it was fairly close to Shanghai and hence possible to visit.

Here is what the shortseller report said about the plant.

In Anhui, which Agritech calls its principal production facility, $400,000 worth of plant and equipment would seem slim for 100,000 tons of production capacity. We visited and found a small plant on a rutted road outside Bengbu, completely deserted.

Lucas McGee give a photograph.

This (surprisingly) was not the plant we found. We found the plant we photographed from following SEC filings.

The annual filing gives the addresses of the plants as follows:

The Anhui plant is giving as Changzheng East Rd, Gaoxin District, Bangfu City. The plant is (according to this part of the annual filing) large (3,400 square meters) and the rent is USD32,488 per month. (You can calculate the rent per square foot and my knowledgeable China contact suggests that this is high for low end industrial rent in China.)

Changzheng (the street name) translates as “Long March”.

There is another SEC filing (a quarterly) which gives a lease agreement for a plant in Bangfu City.

The address is consistent (1188 Changzheng Road Gaoxin District, Bengbu.) I am presuming that these are the same plant - as there is only one plant listed as rented in Anhui in the property section of the annual report.

We have however had problems with this in translation. Some translations have it as "Long Road" Gaoxin District – rather than “Changzheng Road” or “Long March Road”. You can see that translation in using a Google translation of this 2007 job advert.

The lease gives the space as 1338 meters squared – considerably smaller than the 3400 meters square in the annual report. The rent is also considerably less than the annual report (commensurate with size) but the rent per square foot was higher - and high according to my (knowledgeable) contact.

Anyway my contact visited this site – and it is clearly an industrial site – but there is no large fertiliser plant on the site. The ground floor is held by the Bengbu Yi Machinery Factory and the Bengbu Equipment Factory. These are metalworking shops – and their sign is on the front door.

Here is the photograph.

THERE IS AN IMPORTANT CAVEAT REGARDING THIS PHOTO AT THE END...

There were not a large number of people on site. That was not surprising as it was Chinese New Year. There was however a security guard – and my contact talked to the security guard. He had never heard of China Agritech – or even Anhui Agritech. However it turned out that they did have premises on the second floor of the building – though nothing as large as the amounts indicated in either the lease or the annual.

There were no smells associated with organic fertiliser. Organic fertiliser as most people would know smells somewhat.

Moreover – and this is an obvious point – a fertilizer plant that processes 100 thousand tonnes of fertilizer per year is vanishingly unlikely to be on the second floor. 100 thousand tonnes of fertilizer is 2.5 million 40kg bags of fertilizer. Moving this requires trucks and loading docks and the like.

The Security Guard said that the Bengbu Equipment Factory moved here approximately 3 months ago. He was not aware of either China Agritech or Anhui Agritech having any other premises. A cursory online check with the Administration of Industry and Commerce database showed Anhui Agritech only at this address. My lawyer-contact in Shanghai noted that it would be breaking the law to be operating from a second address without including that address in the database.

This all sounds consistent with the Lucas McGee report, however I note a glaring inconsistency. This appears to be a different premise to the one photographed by the shortseller report.

The shortseller premises are a small plant on a rutted road whereas my contact suggested that this was a more urban plant. It would be sensible to have a fertiliser plant at an address closer to the outskirts of town, after all fertiliser is a bulk commodity and organic fertiliser smells. Moreover it is used outside towns – so premises on the outskirts of town make more sense than this site.

It is possible then that the premises are different from the ones mentioned in the annual report. However our contact visited the premises in the annual report and they did not find a fertiliser plant capable of producing 100 thousand tonnes per annum.

China Agritech has claimed Sinochem as a major customer. Lucas McGee says that they talked to Sinochem and Sinochem denied being a customer. The company in their defence has pointed to an SEC filing that details a contract with Sinochem. Here is that filing.

The filing is interesting. It is for liquid fertiliser and in surprisingly small quantity. The contract is for liquid fertiliser in tiny bottles. I quote:

These are tiny bottles – sometimes only 15ml and always less than one fifth of a litre. The contracts include packaging. A 15ml packet is probably enough for one to five shrubs - not a commercial farm. The instructions (in Chinese on China Agritech's website) suggests that the liquid be diluted 1000 to 1 before watering plants. A 15ml packet would do a watering can.

The total contract is for just over a million litres – or just over a thousand tonnes. This is tiny for a company that produces (or claims to produce) over 200 thousand tonnes per year of fertilizer - and indeed the main product appears to be packing and handling.

This Sinochem contract is probably real (contrary to the suggestions of the shortseller). But the contract is tiny and unlikely to be financially relevant.

Moreover, the contract is not agricultural supply (which is done in bulk) rather a packaging contract for the sort of product someone use to fertilize their home flower patch. I might buy a small bottle of fertilizer for my (postage stamp size) backyard.

Moreover this contract is consistent with what the shortseller said about the company – they said that the company produced small quantities of liquid fertiliser at Pinggu County on the outskirts of Beijing. Indeed the contract was signed in Beijing.

The company's photographic evidence

The company has presented several photos to prove the plants are there. The photos show plants but without loading docks or the like. They also show liquid fertilizer packing. They show a total of five 40kg bags of mixed organic/NPK fertilizer.

They are however not supportive of the proposition that this company produces 200 thousand tonnes (5 million 40kg bags) of dry fertilizer annually.

Several of the photos are of packaging and distributing very small quantities of liquid fertilizer. Here is one example.

Summary

I sent a researcher to the company's stated main premise to see if I could find a plant capable of producing 100 thousand tonnes per annum of bulk fertiliser. We did not find that plant.

The company has protested there is one there. The premises appear different from the one the shortseller visited – but I found stuff consistent with what the Lucas McGee report and inconsistent with what the company says.

The Lucas McGee report said that no contract with Sinochem existed. I am satisfied that Lucas McGee is wrong on that point. A small contract for liquid fertiliser for retail use exists – and the company is capable of bottling such a product. However it is entirely possible that no bulk-dry-product contract with Sinochem exists. The contract in the SEC filings does not support the proposition that Sinochem is a meaningful customer relative to China Agritech’s claimed sales.

China Agritech has produced photos to support the existence of their main business. These photos are alas entirely consistent with the shortseller claims - in that they do not support the proposition that there is a business capable of distributing 5 million bags of fertilizer. Moreover none of the photos is labelled or geo-tagged in any way that helps verify the existence of the company.

I am staying short.

John

Some people have noticed - that unbeknown to me - my Chinese contact took the photo of the gate from a website.

I agree the document is IDENTICAL to the one taken from the website. I instructed him clearly to TAKE photos -

He just says "Here is a picture of the gate". He never told me he TOOK the picture of the gate. Though my instructions to him were clearly TAKE PHOTOS.

I will follow up with photos HE TOOK.

----------------

The current state of play is this: The lawyer in the states had a colleague swing by the factory on her way home. She was visiting her family in Anhui for Chinese New Year and SHE provided photos including photos of the metalworking. She also provided the photo of the factory gate - a photo that perplexed me because it was NOT a photo that matched the photos in the Lucas McGee report.

My lawyer in Shanghai cannot explain why the photo came from the website and was not taken on her phone.

He is trying to follow this up. I will have a further follow up details when available.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.